Q2 2022 Market Recap And Economic Review

Introduction

In our first outlook for 2022, we expected economies to shift from an acceleration phase to a moderation phase with higher market volatility, larger and more frequent drawdowns and lower expected returns.



The 4Rs: Russia, rates, risk, and recession are on investors’ minds as markets continue their volatility due to:
- Trade frictions
- Supply chain issues
- Elevated commodity prices
- Tight labor markets and expensive services



Increasingly hawkish central banks are sending mixed signals to global economies, affecting consumer and investor sentiment.

Inflation in May reached 8.6% year-on-year, its highest since 1981. The Federal Reserve (the “Fed”) raised rates by 0.75%, the biggest hike since 1994.



Growth estimates are being reevaluated. Several institutions, including the International Monetary Fund (IMF) are reducing growth forecasts.

Global Overview

Main indices year to June 2022 performance

The semi-annual performance of various indices so far is among the worst on record.

Source: Bloomberg

GDP growth estimates have been reduced

Sustained inflation and the Ukraine-Russia conflict have slowed global economic growth from an estimated 6.1% in 2021 to 3.6% in 2022 and 2023. These forecasts are 0.8% and 0.2% below the January projections for 2022 and 2023, respectively.

Source: THE IMF

High inflation is the main catalyst behind markets underperformance

Sources: FRED,BLOOMBERG

And supply chain issues remain

Source: BLOOMBERG

High inflation is pushing the central bank to tighten policy

Previous rate hikes lasted 24 months on average, with an average increase of 3%. While some tightening cycles lasted 14 months (e.g. May 1999), others lasted as long as 46 months (March 2015). Rate hikes may continue until Q4 2023, reaching 3% to 4% if inflation remained elevated.

Source: FRED

A tightening policy is matched by higher yields

While interest rates have increased, the spread between two-year and 10-year treasury rate signals market uncertainty in the short term.

Source: BLOOMBERG

While the yield curve might be inverting

Source: BLOOMBERG

Potential reasons for further downside

Indicators, including the yield curve inversion, indicate further downside.

Inverted yield curveAn inverted (negative) yield curve occurs when longer-term yields drop below short-term ones for debt of the same credit quality. An inverted curve has been a relatively reliable lead indicator of a recession.

High inflationRising prices reduce consumer purchasing power leading to reduced spending.

Low ISM Manufacturing IndexThe ISM manufacturing index is a key monthly indicator of U.S. economic activity based on a survey of purchasing managers at more than 300 manufacturing firms. The index measures demand based on ordering activity at the nation's factories.


Geo-political uncertaintyThe Russian-Ukrainian conflict has a severe impact on the global economy, creating forced population displacement, higher commodity prices (including energy), and a global supply chain disruption.

Other indicators show signs of relief

Economic data such as unemployment and the Case Shiller index are encouraging

Strong labor marketUS unemployment in May 2022 was unchanged from the previous two months at 3.6%, down from 3.9% in May 2021 and the lowest since February 2020. Meanwhile, the labor force participation rate edged up to 62.3% from a three-month low of 62.2% in April.

Resilient housing marketJune 2022 S&P CoreLogic Case-Shiller Indices, the leading measure of U.S. home prices, continue to show rising home prices across the U.S. The S&P CoreLogic Case-Shiller U.S. National Home Price NSA Index, covering all nine U.S. census divisions, reported a 20.6% annual gain for March 2022.



Positive PMIThe Manufacturing Purchasing Managers’ Index (PMI) is an indicator of business activity in the manufacturing sector, providing information about current and future business conditions. In June, the PMI index was 52.70. A score greater than 50 indicates an expansionary economy while a score below 50 forecasts a sluggish economy.

Credit market spreadsThe option-adjusted spread (OAS) on the S&P U.S. High-Yield Index, a measure of the risk premium demanded for high-yield bonds, rose more than 2.50% from the start of the year to 5.6%. However, average spreads were much higher in previous recessions and the OAS is still just below its 25-year average.

Strong indicators belie gaps under the surface

Despite low unemployment, the rise in part-time employees for economic reasons may foreshadow a looming weakness in labor markets. A similar divergence with unemployment occurred before the global financial crisis.

Source: BLOOMBERG

Fundamentals

Managing bull and bear cycles

Identifying the relevant cycle and positioning the portfolio accordingly help reduce losses and improve risk management in bear cycles while capturing a better upside in bull cycles. Recession and cyclical bear markets tend to last less than post-recession and post-cyclical bull markets. Since 1968, the recession and cyclical bear markets averaged 528 days and 207 days, respectively, while post-recession and post-cyclical bull markets averaged 563 days and 1064 days, respectively.
Source: BLOOMBERG

The correction has not yet factored lower anticipated earnings

Lower earnings are expected due to higher labor and raw material cost amidst supply chain bottlenecks.

Source: BLOOMBERG

The correction has not yet factored lower anticipated earnings

In previous recessions, corporate profits and consumer sentiment fell in tandem, which has yet to happen. However, the gap should close when corporate profits are negatively impacted.

Source: BLOOMBERG

S&P 500 has record earnings

Although S&P 500 earnings are at all-time records, a recession can trigger significant drops in profitability.

Source: BLOOMBERG

Private markets outperform public ones during major slowdowns

Source: Private Equity / Real Estate returns from Cambridge Associates. S&P500 / Dow Jones Equity REIT Index from Bloomberg

Despite record profits and lower valuations, further downside is expected

Reduced valuations in public markets, notably the S&P 500, may drop further after earning revisions. In previous inflationary environments where CPI exceeded 3%, the median and average correction in price to earnings (P/E) were 20% and 30%, respectively. The S&P P/E was around 22.0x when the Fed started hiking rates in March 2022, which might indicate further downside as earnings are revised

Source: Bloomberg

The credit market tells a different story

When bond prices drop, the high-yield spread tends to widen. Although the option-adjusted spread (OAS) has widened, the readings remain far below those in previous recessions. This indicates either that the credit market is near the bottom after the high-yield index fell as much as 14.19%, or that credit spreads are still catching up. The High-Yield OAS is slightly below its 25-year average of 5.43%

Source: Bloomberg

Labor and housing markets show encouraging signs.

Could corporate profits still rise to record highs despite worrisome macro events?
Source: Yield Curve: 10 2Yr differential: US Personal Consumer Expenditure YoY . Labor: U.S. Unemployment %. Credit Performance: U.S. High yield spreads. ISM MFG: U.S. PMI. Earnings: S&P YoY Earnings growth. Housing: U.S. House Price Index.

Sentiment

Investors consider central banks the biggest “tail risk” this year

Source: Bank of America Global Fund Manager Survey

Investor sentiment

The Fear and Greed Index (which uses seven factors including market momentum, safe-haven demand, and junk bond demand) showed fear at 29 as of June 28, 2022. Although sentiment has fallen significantly since the start of the year, it has improved from extreme fear conditions, implying that there is no market capitulation yet.

Source: CNN

Consumer and corporate sentiment

Source: Bloomberg

What this mean to your portfolio

Potential medium-term scenarios

Four potential medium-term scenarios can define the next market cycle. Each scenario impacts your portfolio differently.

Market cycles and positions

A two-phase plan is underway

Phase  I

Take advantage of market dislocations in liquid assets during the bear market phase, focusing on high-yield/loan credit and banks

Phase II

Take advantage of market dislocations in illiquid assets during the recovery phase

Conclusion

Low investor and consumer sentiment echoes past recessions.

High-yield and investment grade bond yield spreads are widening due to higher interest rates.

Balance sheet reduction by central banks may reduce growth as markets lose a valuable source of liquidity.

The prolonged conflict in Ukraine continues to pressure prices of energy and other commodities. It is important to monitor the following:



Inflation signals such as:
- Inventory accumulation
- Commodity prices
- Industrial goods
- Government spending

Economic indicators:
- OAS High Yield spread
- Unemployment
- Case Shiller Index
- Earnings revisions



Our Position

We remain invested selectively in private assets, as private equity and real estate have outperformed other asset classes historically during economic slowdowns.

We continue to seek opportunistic investments, underwriting exit scenarios conservatively and detecting tactical opportunities that protect our investors’ portfolio

We increased our cash allocation significantly

We favor cash-flowing investments, such as private debt, real estate value-add and real estate debt

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